How Apple scores its lower tax bill

Apple is one of America's most profitable companies. And it pays a substantial income tax bill to the U.S. government -- by its own account, $6 billion in 2012 and an estimated $7 billion this year.

But many tax experts and lawmakers say Apple's tax bill should be bigger. A lot bigger.

The concern is that Apple(AAPL), while complying with U.S. laws, is nevertheless taking advantage of loopholes in the tax code to shift a substantial amount of income to offshore subsidiaries in low-tax countries. The result is billions of dollars in profits every year that go untaxed.

Apple is hardly the only American company to minimize its offshore tax bite. But it has become a poster child for it.

In Apple's case, the focal point is its subsidiaries in Ireland, where the company faces a maximum tax rate of just 2%. That's well below the 35% top rate in the United States and even well below Ireland's top statutory rate of 12.5%.

Apple CEO Tim Cook told lawmakers on Tuesday that the company is not engaging in tax "gimmicks" and shifting profits overseas. The company's tax strategies serve both the interest of Apple shareholders and help create many jobs in the United States, he said.

Nevertheless, as lawmakers consider how to reform the corporate tax code, they will be taking a hard look at how offshore profits are managed.

Here are some of the techniques at the heart of the controversy over Apple's offshore tax strategies:

Let offshore subsidiaries enjoy outsized profits: Most of Apple's research and development is done in the United States. But some of those R&D costs are borne by its Irish subsidiaries under what's known as a cost-sharing agreement.

That, in turn, lets the subsidiaries enjoy the economic benefits that result from the R&D -- namely the profits from the intellectual property that's created, noted Martin Sullivan, chief economist at the publisher Tax Analysts.

The problem, tax experts say, is that Apple's Irish subsidiaries appear to get a sweetheart deal for their R&D investment -- the kind of deal that the company wouldn't give to an outside entity that might want to get in on the ground floor of the next great Apple product, Sullivan said.

From 2009 to 2012, one of those Irish subsidiaries -- Apple Sales International -- contributed $4.9 billion to Apple's R&D costs. But it booked pre-tax profits of 15 times that amount, or $74 billion.

By contrast, Apple's U.S.-based operation contributed $4 billion to R&D and only enjoyed profits of about nine times that amount ($38.7 billion).

Given the intangible value that the U.S.-based business provides to the Irish subsidiary -- namely the facilities, talent and know-how to conduct R&D -- it would seem the Irish subsidiary paid less than a fair-market price for the profits it booked, Sullivan explained.

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A report from the Democratic and Republican leaders of the Senate Permanent Subcommittee on Investigations further notes that "the company operates in numerous countries around the world, but it does not transfer intellectual property rights to each region or country where it conducts business. Instead, the transfer of economic rights is confined to Ireland alone, where the company enjoys an extremely low tax rate."

Set up no-man's-land subsidiaries: Even though Apple has incorporated its subsidiaries in Ireland, the two main ones are not legally considered tax residents of Ireland nor of the United States.

That includes the holding company for most of its foreign subsidiaries -- Apple Operations International. AOI reported net income of roughly $30 billion between 2009 and 2012, but it did not file a corporate income tax return and didn't pay any corporate income tax -- to anyone -- for five years, according to the Senate report.

Keep profits offshore indefinitely: Companies owe U.S. tax on the profits they earn abroad, but only when those profits are brought home.

When the money is "repatriated," the company must pay the U.S. corporate tax rate of 35% minus whatever foreign tax they already paid on those profits.

Apple has said it has no current plans to bring back the $102 billion it has in cash located offshore.

So, in addition to avoiding the 35% tax on that money indefinitely, it may -- and does -- use that offshore cash to make U.S.-based investments. Under the law, that is not considered "repatriation," and Apple only has to pay U.S. tax on some of the income those investments throw off.

"Disregard" certain Apple entities: Under a complex but porous set of rules in the U.S. tax code originally intended to prevent companies from shifting profits to tax havens, corporations are allowed to "disregard" some of their entities and their transactions for U.S. tax purposes.

When they do, the transactions of those entities effectively disappear -- or "go poof," as Richard Harvey, a Villanova University professor of tax law, put it during testimony before the Senate subcommittee.

The Senate report found that in using this technique from 2009 through 2012, Apple managed to "avoid $44 billion in taxes on otherwise taxable offshore income."